Speech
Monetary Policy and Economic Growth

Introduction

It is a pleasure to be in Perth to address the Western Australia Division of the
Institute of Company Directors. It is also fitting that I should be talking
about economic growth, since Western Australia has set an example to the rest
of Australia by its high growth rate in the 1990s. Some would say this is inevitable,
given its resource base, but we have seen internationally that the fastest
growth does not coincide with the biggest resource endowments. Enterprise and
a willingness to embrace change are also vital ingredients, and here Western
Australia has also distinguished itself.

In the Reserve Bank we are often drawn into a discussion of economic growth because
of claims that we have a ‘growth ceiling’ of 3½ per cent
per annum. I do not know where this perceived ceiling came from, and I have
on several occasions denied its existence. I will do so again tonight.

It has been suggested to me that one of the reasons for this belief is that I have
often highlighted the data contained in Table 1 below, particularly when I
have been doing my patriotic duty in front of audiences of overseas investors.
It shows that over the past six years, that is the period of the current expansion,
we have grown at an annual average growth rate of 3.5 per cent. This is very
good by the standards of the ‘high income OECD countries’. Only
Ireland has done better, and Norway and New Zealand have grown at about the
same rate as we have. These are all much smaller countries than we are (their
combined GDP is less than Australia's). The other thing that stands out
from this table is how well the English-speaking countries have done in the
nineties; the six English-speaking countries are in the top seven spots.

Table 1: OECD GDP Growth over the Past Six Years

Average annualised growth

Real GDP

Ireland

6.4

Australia

3.5

Norway

3.5

New Zealand

3.4

United States

2.7

United Kingdom

2.4

Canada

2.2

Denmark

2.1

Netherlands

2.0

Austria

1.7

Japan

1.6

Spain

1.5

Finland

1.5

Germany

1.4

Belgium

1.3

France

1.3

Italy

0.9

Sweden

0.9

Switzerland

−0.1

Source: OECD

The 3½ per cent per annum contained in this table is there for international
comparisons, not as a yardstick for what we can do this year, next year or
the year after. For a start, that six-year average of 3½ per cent contains
years like the past 12 months where we have achieved only 2.4 per cent, but
there are other periods like the year to September 1994 when we managed 5½
per cent.

Economic Growth over the Cycle

While we do not have a growth target or growth ceiling, we do have an inflation target.
This says that inflation should average somewhere between 2 and 3 per cent
over the medium term. That is, when we look back, we should see that it has
averaged 2-point-something per cent, even if we have been over 3 per cent on
some occasions and below 2 per cent on others.

This approach is not, as some might think, anti-growth. It is, in fact, pro-growth
by favouring forward looking management of the business cycle, which will help
in achieving a stable platform for long-run growth. The other way of expressing
an inflation target is to say that the economy should grow as fast as possible
consistent with maintaining low inflation, but no faster. We say no faster
because post-war experience in a number of countries has shown us that allowing
inflation to rise too much actually harms growth prospects in the longer term.
Sustained periods of strong growth have always gone hand in hand with low inflation.
Weaker growth occurred in the high inflation era, particularly between the
mid-seventies and mid-eighties.

We have also emphasised that it is the length of the expansion that is important.
Our last two expansions were cut short by inflationary pressures after about
six-and-a-half years. It would probably be possible on this occasion to engineer
a short-lived boom, characterised by rising output and falling unemployment,
but also by increasing inflation, unrealistically high asset values, inflated
paper wealth and financial instability – which is, of course, a recipe
for a slump thereafter. Recessions may come for some other reasons, but there
is no reason to run a high risk of a self-inflicted one. It is important that
we take a longer view in order to achieve a longer expansion. The value of
the inflation targeting regime is that it forces us to do precisely that. That
is why I am confident that, under our present arrangements, we will be able
to do all that can be done to foster a long expansion.

What does this mean for the next couple of years? That is really a matter of forecasting
rather than speed limits. With inflation tamed, and with some slack available,
we should be quite capable of growing by 3½ per cent, 4 per cent, 4½
per cent (or possibly even faster) over the next couple of years without any
significant detrimental effect on inflation. None of these figures is a target;
they are simply illustrative of the sorts of numbers we might reasonably expect
to see after a period of sub-par growth such as 1996.

Ideally, as we grow fast enough to take up existing slack, businesses would lift
investment rates further, pushing the capacity constraints further back. If,
at the same time, we found that labour market arrangements were able to bring
new employees onto payrolls without generalised pressure on wages, we would
be able to sustain faster growth for longer. In other words, by having a longer
expansion, we would be able to drive unemployment down further.

How likely is that outcome? It is hard to say. We do not have a doctrinaire view
on what can be achieved. We will evaluate the evidence as it comes in. Critical
in that evidence is the course of prices. The main test of what is sustainable
on the growth front is the inflation test: is the rate of growth compatible
with achieving the 2–3 per cent average for inflation, looking forward
as best we can over a year or two? If the answer is yes, then that growth is
sustainable, at least at that point in time. To repeat: we do not have a growth ceiling, beyond which the brakes automatically go
on. We have an inflation target, appropriately and flexibly defined, which
tells us to tighten when our forecast of inflation has it exceeding the target
for any sustained period of time, and to ease when the forecast has inflation
sustainably below target. Growth
per se does not necessarily trigger this response: it is
the inflation outlook which is important. In thinking about the inflation
outlook, of course, we need to ask ourselves whether the growth which is occurring
now and that which is in prospect are likely to put pressure on capacity to
such an extent that inflation might rise noticeably. But that is a judgment
based on a range of factors, not a mechanical response to the breaching of
some arbitrary growth threshold.

Another point I would like to make is that at the moment I do not see that monetary
policy is placing any constraint on growth. This is as it should be –
one of the advantages of an inflation target is that it makes sure monetary
policy is eased when the inflation forecast is below the target average. Hence
the five easings over the past year. This might help to reassure those people
who think that in order to maintain a low average inflation rate, monetary
policy has to be kept continuously tight. It does not – monetary policy
will be eased as often as it is tightened. Monetary policy has to be no tighter
to maintain an average inflation rate of 2½ per cent, than to maintain
an average of 5 or 10 per cent. In fact it probably would have to be tighter
at the higher figures as it would be fighting against rising inflationary expectations.

Another sign that present monetary policy is not restrictive is to look at the effect
it is having on the cost and availability of credit. If this was too expensive,
we would not see much being used, but that is not the case at present. All
forms of credit – business, housing and personal lending – have
been growing at somewhere between 8 and 11 per cent over the past year. This
does not suggest that the economy as a whole is finance-constrained, although
there will always be some individuals or firms that are.

Another manifestation of this that may have escaped many people is that we now have
lower interest rates out to five years than the United States, which is the
usual benchmark for international comparisons. Now this is entirely fit and
proper, given the different cyclical positions of the two economies and given
our lower inflation. But even so, it would have been unthinkable even a few
years ago. Financial markets took it for granted that Australia would always
be a high interest country relative to the United States. (International investors
put Australia in with a group of countries called the ‘high yielders’.)
I am strongly of the view that these lower interest rates are a substantial
benefit for Australian businesses.

Economic Growth in the Long Run

So far, we have been talking about growth over short time horizons such as a couple
of years or so. Over this horizon, growth can vary quite a lot, and monetary
policy will have some influence on the outcome. While monetary policy's
major long-term influence will be on the rate of inflation, over shorter periods
it can have a significant influence on economic activity and employment. If
it is too tight, it will unnecessarily constrain them, and if it is too loose,
it could set up the conditions for an inflationary boom. The relationship between
monetary policy and economic growth is thus essentially a short-term or cyclical
one.

But this is not what a lot of people are interested in. They want to know what is
Australia's long-term growth potential. Is our potential growth rate relatively
low like all the standard OECD countries in Table 1? Is it a bit higher? Or,
alternatively could it be as high, or nearly as high, as the newly industrialising
countries of Asia? How could it be raised to a higher figure?

These are all difficult questions to answer, and I shall only attempt a very cursory
one. But before I do that, I want to make an important point – whatever
our potential growth rate is, monetary policy will have little to do with it
compared with other factors. Monetary policy mainly works by affecting aggregate
demand in the economy. Fluctuations in demand are the normal (though not exclusive)
source of business cycles. In thinking about long-run trends, however, it is
the supply structure – the economy's capacity to produce and
how that can be increased – that is crucial.

Perhaps I can take the liberty of illustrating this distinction between short and
long run with a stylised diagram. An economy could have an average long-term
growth rate as shown in the straight line Trend A. Its actual growth will never
be a straight line because of the business cycle, so it is likely to look like
the wavy line Actual A. If monetary policy was conducted badly, we could end
up with a boom and bust given by the grey line Actual A'. Alternatively,
if monetary policy was conducted well, we should expect to have relatively
stable conditions, including low inflation; with a bit of luck, we should also
get longer lasting expansions and milder recessions. Because a reasonably stable
aggregate price level does not prompt the distortions in economic decisions
seen with high inflation, trend growth should be a little higher. But while
that difference will be worth having, it only adds a little to trend A, and
many people would have trouble noticing the difference.

Now, people may be unsatisfied with this outcome and say that they would prefer to
be on the faster trend growth line given by Trend B, which is perhaps two or
three per cent higher than Trend A. This is a reasonable aspiration, but it
cannot be achieved by an adjustment to monetary policy.

Diagram 1

What factors then explain long-run growth? In simple terms, it is explained by the
growth of the productive factors in the economy – the growth of the labour
force, expansion of the capital stock and growth in productivity of both labour
and capital. This is why there is such focus on microeconomic policies to raise
efficiency, rather than manipulation of the macroeconomic instruments, when
people talk about long-run growth potential. Again, all that monetary policy
can do is to minimise the booms and busts around the higher trend. The only
way that the economy can move from Trend A to Trend B is by enacting policies
that either increase the growth of the productive factors or increase their
productivity.

I do not intend to say much about the growth of the labour force, which in the long
run is determined by population growth and participation in the workforce.
Note, however, that in the short run the economy can grow faster than the labour
force constraint would suggest because, if there is enough flexibility, we
can move people out of unemployment into employment. The other point that I
should register is that I do not think in the long run we will be able to maintain
our current low male participation rate. With life expectancy still increasing,
we will not be able to continue the luxury of having so many people entering
the workforce in their early twenties and leaving in their mid fifties. This
is a transitory phase, not a permanent increase in leisure.

In thinking about how to ensure that the capital side of production potential is
expanded sufficiently, it is hard to go past the simple idea that investment
has to be funded by saving, and we would probably have more if we increased
our domestic saving. Of course it could be funded by more foreign saving, but
that path tends to be a more unstable one. I have no new ideas on how to increase
our savings other than through the familiar methods of making sure that the
government does not reduce national savings through chronic budget deficits
and by enacting measures to make sure that a higher proportion of retirement
incomes are funded out of private savings.

The really big issue for long-run growth is how we raise productivity. In simple
debate, this is often portrayed as producing the same with less people, either
by job shedding or by substituting capital for labour. But any business knows
that it is not just manning levels which are important. The flexibility of
the workforce in using the capital equipment, the skills which they can bring
to bear in response to new demands and opportunities, the capacity of the firm
to innovate and improve processes in industrial and service applications, the
ability to develop and exploit new technology – these are actually more
important ingredients in the long run.

Of course, all good firms are trying to do this all the time. In a competitive marketplace,
they have to keep up with their competitors or fall by the wayside. In a global
marketplace, they increasingly have to move towards international best practice,
which itself is always advancing as a result of innovation and adoption of
new technology. In the process of matching their competitors, the best firms
drive the development of productivity and the rise in living standards.

Not all firms nor all industries will succeed in doing this. Some will thrive and
others will fail. Some industries will grow, and some industries that we do
not even know about as yet will emerge. The only thing we know is that there
will be continuous change, not just here but in all countries, under the constant
pressure of competition, new technologies and globalisation. There is no simple
secret to success, but part of the answer must be for both firms and for countries
to facilitate change, and to adapt to it, not to resist it. The central issue
is that all productivity gains involve change. By their nature they involve
producing goods and services in different (and better) ways, or in producing
different goods and services. Change is a necessary condition for productivity
growth.

These major changes are going to occur in the private sector among both large and
small firms. The adjustment task will be difficult, but they must try to seek
out the profitable and growing areas. While the role of government will be
important, the Government will not be able to do the adjustment for the private
sector. I find it hard to believe that the Government would be better than
the private sector at picking the growth areas, so I believe that the Government's
main contribution should be to remove unnecessary obstacles to change, to provide
a high quality infrastructure, to encourage saving and to work at lifting and
maintaining quality of education.

I know this is a difficult message to give to a public which is growing tired of
change (not all of it economic). But the alternative of stopping change is
really not viable. It has always been the case that the firms and societies
that have managed to embrace the challenge of change and seize new opportunities,
rather than turning their backs, have been the ones that prospered.

It may, of course, be harder for the high income societies like Australia than for
the newcomers who feel less attachment to established ideas and who therefore
have less to ‘lose’ in embracing change. But we surely have the
capacity to adopt change when we see the need. We have to be convinced it is
worth it.

The advantages of flexibility have been well demonstrated in the nineties by the
superior performance, both in terms of growth and in lower levels of unemployment,
of the less regulated English-speaking countries compared to the corporatist
European ones.

I am not suggesting we should remove all regulation and rely totally on laissez-faire. There is clearly a large role for government,
but we should always ask whether particular government initiatives are forward
looking, or whether they are protecting an existing industry or an existing
privilege.

The first requirement of government is to provide as stable a macroeconomic environment
as it can. The second requirement of government is to provide first class,
low cost infrastructure. This stretches from such items as the legal system
and accountancy standards through to more tangible items like the education
system and the utilities, including electricity, gas, water and telecommunications.
The Government, of course, need not be the provider of each of these, but it
will always ultimately set the standards. Inevitably, governments will also
be called upon to enact policies which affect one industry at the expense of
others. My only plea here is that they do it in a way that encourages adjustment,
perhaps even compensates losers, but not to do it in a way which resists change.

Conclusion

Australia has recorded quite a respectable growth performance by developed country
standards during the current upswing. Even our low point in the mid-cycle growth
pause – a bit over 2 per cent – is pretty good compared with many
countries' average performances. People are disappointed that more progress
has not yet been made on reducing unemployment, but we have made some, and
further real progress will be made if we can sustain a long running expansion.
As I have noted tonight, I think our current monetary policy framework is serving
us well in this regard, by requiring us to take a medium-term view in our policy
deliberations and maximising the chances for a long recovery. I hope I have
helped to explain our thinking.

When we shift our focus to the economy's long-run growth prospects, however,
monetary policy should inevitably attract less attention. Price stability is
a necessary condition for faster long-term growth, but there are many other
policies which have to be got right. That's why it is so hard. If there
is a simple message, I think it is that the heart of the long-term growth process
is productivity enhancement through innovation, technological change and so
on, and that to reap the benefits of those processes, we have to embrace the
forces of competition and globalisation, with all the changes and discomforts
they bring.